BHP: What the market missed

BHP reported its financial results for the first half of the 2018 financial year this afternoon. Underlying earnings were marginally disappointing mainly because of operational and geotechnical issues at the Broadmeadow and Blackwater coal mines. Before the result, BHP had flagged lower volumes and higher costs in the coal division. But the result proved a little worse than expected.

Overall, the result again evidenced BHP's improving financial position. Net debt fell to $15bn thanks to firm commodity prices, good cost control and ongoing capital discipline and despite a hefty catch-up cash tax payment of $1.3bn in the half. Gearing is now at 19.9% and we expect it to continue falling from these levels.

BHP’s productivity initiatives were confirmed in the result with BHP still expecting $2bn in benefits by 2019. Capital expenditure is expected to be less than $8bn per year until 2020, substantially lower than peak cycle levels reflecting better capital discipline and an increasing focus on the best-returning projects. Return on capital employed has reached 12.8% and is likely to rise further.

Progress on shale asset sale

BHP also provided an update on the sale of the onshore US shale business. The sale process is tracking to plan with early interest expressed from potential buyers. We expect good progress in the next 6 to 12 months on this front. BHP is opening a data room in March and is adding tension to the bidding process by keeping all options on the table, including trade sale, IPO or demergers. The onshore US shale business is BHP’s poorest returning division (the only division with a negative return on capital employed). We strongly support BHP’s plan to sell these assets. Purported shale industry returns are illusory in our view. The industry has failed to generate free cash flow in both high and low oil price environments during the last decade. Operating cash flow is perpetually reinvested to maintain production. We expect BHP’s eventual exit from the onshore US shale business to be taken very well by the share market.

In contrast, BHP’s conventional petroleum development plans focusing on Trinidad and the Gulf of Mexico (including the Mad Dog 2 project which is tracking to plan) are attractive investment options. BHP’s exposure to conventional oil is under-valued in our view, especially given our positive outlook for the oil price. We believe oil markets are tightening significantly. Strong demand is likely to outstrip supply additions driving a significant reduction in global oil inventories over the next 12 months.

What the market is missing

The iron ore price should also surprise to the upside this year. Downstream indicators of Chinese domestic steel demand remain robust thanks to ongoing investment in large-scale infrastructure projects.

Equally important, Chinese supply-side reform in the steel industry has led to a structural change in steel mill utilisation and an expected ongoing preference for high-grade iron ores that BHP produce. The current elevated premium for high-grade iron ore is likely to persist for longer than the market expects and is great news for BHP.

Overall, BHP’s free cash flow generation is therefore expected to remain robust with both oil and iron ore, key commodities for BHP, bettering consensus expectations this year.

Cost control and capital discipline and an exit from onshore US shale will also drive significant debt reductions providing BHP with options to reinvest for growth over time should the right opportunities arise.

And the stock is cheap. For now, the equity market doesn’t believe BHP’s strong free cash flow generation is sustainable despite demonstrable evidence global activity is picking up, demand for commodities is strong and China is serious about supply reform.

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